For markets to be efficient, prices should adjust quickly and rationally to the release of new information. In other words, prices of assets in an efficient market should “fully reflect” all information.
Market Participants
One of the most critical factors contributing to the degree of efficiency in a market is the number of market participants.
Information Availability and Financial Disclosure
Information availability (e.g., an active financial news media) and financial disclosure should promote market efficiency. Information regarding trading activity and traded companies in such markets as the New York Stock Exchange, the London Stock Exchange, and the Tokyo Stock Exchange is readily available. Many investors and analysts participate in these markets, and analyst coverage of listed companies is typically substantial. As a result, these markets are quite efficient. In contrast, trading activity and material information availability may be lacking in smaller securities markets, such as those operating in some emerging markets.
Limits to Trading
Arbitrage is a set of transactions that produces riskless profits. Arbitrageurs are traders who engage in such trades to benefit from pricingdiscrepancies (inefficiencies) in markets.
Some market experts argue that restrictions on short selling limit arbitrage trading, which impedes market efficiency. Short selling is the transaction whereby an investor sells shares that he or she does not own by borrowing them from a broker and agreeing to replace them at a future date.
Transaction Costs and Information-Acquisition Costs
The costs incurred by traders in identifying and exploiting possible market inefficiencies affect the interpretation of market efficiency. The two types of costs to consider are transaction costs and information-acquisition costs.
- Transaction costs: Practically, transaction costs are incurred in trading to exploit any perceived market inefficiency.
- Information-acquisition costs: Practically, expenses are always associated with gathering and analyzing information.
